Are Brokers and Financial Advisors Ripping You Off?

With more than three decades' worth of his annual letters to Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) shareholders posted on Berkshire's website, there are plenty of great Warren Buffett stories to choose from. But one of my personal favorites from the Buffett archives is his parable of the Gotrocks family.

Meet the Gotrocks
Buffett first told the Gotrocks story in the 2005 shareholders' letter (PDF file, Adobe Acrobat required) under the heading "How to Minimize Investment Returns." And who, exactly, are the Gotrocks? They're a fictional family that owns every American corporation -- thousands of companies that annually earn (as of 2005) around $700 billion. It's a pretty sweet setup for the Gotrocks clan.

But the Gotrocks family's investment life doesn't remain tranquil. Here's Buffett:

[L]et's now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family's annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.

The problems don't end there, because soon a second class of Helpers enters the picture:

"Hire a manager -- yes, us -- and get the job done professionally." These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.

It doesn't end there. The hapless Gotrocks are inundated with one layer of Helpers after another, each taking their cut. The joke, of course, is on the Gotrocks, because the maximum income they can receive will always be the total income of all the companies that they own, but they end up further and further from that maximum as they pay ever more fees to the Helpers.

Helping is big business
Helping (in Buffett's sense) is a massive industry. Thanks in large part to the acquisition of Merrill Lynch and its "thundering herd" of brokers, Bank of America's (NYSE: BAC  ) wealth management division is gigantic. It brought in more than $17 billion in total revenue in 2011 and earned the bank $1.6 billion in net income. Wells Fargo's (NYSE: WFC  ) brokerage clients house $1.1 trillion at the bank and it ended up with $1.3 billion in profits from that division in 2011 on $12.2 billion in revenue.

And those are just a couple of the big boys. They're joined by other giants such as UBS and Morgan Stanley Smith Barney, as well as legions of smaller companies and independent advisors.

Take, take, take?
In a technical sense, Buffett is 100% correct -- for every penny that brokers and financial advisors take, we, as a whole, earn less. (You got that we're the Gotrocks, right?)

But does the story end there? Are brokers and financial advisors simply fast-talking financial-industry leeches, eagerly sucking the green out of our portfolios? Or is there legitimate value being added by brokers and advisors?

I want to hear what you have to say. Whether you're a financial advisor or broker yourself, or you're a customer who's worked with a financial advisor or broker, I want to hear your story. Send an email to tips@fool.com or scroll down and tell us your thoughts in the comments section below.

The Motley Fool owns shares of Bank of America and Berkshire Hathaway. The Fool owns shares of and has created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Bank of America, Morgan Stanley, and Berkshire Hathaway, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (16) | Recommend This Article (32)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 09, 2012, at 4:59 PM, sheldonross wrote:

    This is not a new perspective. People have been saying this about the banking industry in general for years and years.

    The lumberjack cuts down a tree, the contractor builds the house, the buyer fulfills some other aspect of society.

    Yet who owns the house? The bank.

    Industry creates wealth, while the banks facilitate the movement of. All the while skimming of the top.

    The fractional reserve system exacerbates this by allowing the banks to control far more wealth than they actually should.

    Think about this, every product (house, car, TV, etc.) that exists right now, has already had every bit of labor and effort already sunk into it. It's already paid for in reality. Yet banks own a large percentage of houses and cars.

  • Report this Comment On March 09, 2012, at 5:58 PM, tryan102790 wrote:

    The banking system and capital markets, although highly imperfect, create leverage. Used properly leverage accelerates allocation of $$ and facilitates faster growth. This story is, however about how brokers do or don't help add value. Clearly a lot don't...but theoretically, if they find you revenue streams that are growing ...they help clients claim a piece of that growth pie. Key assumption missing in Mr Buffets argument is the pie grows.

  • Report this Comment On March 10, 2012, at 1:04 PM, MyWeed26 wrote:

    I always handled my stocks myself but I have now reaching the age (86) that I do not feel comfortable handling my financial affairs alone-

  • Report this Comment On March 10, 2012, at 3:21 PM, Vikin999 wrote:

    Until you can comfortably manage some or all of your investments choose an advisor who can work for your best interests as a fiduciary with no load funds.

  • Report this Comment On March 10, 2012, at 5:58 PM, lesailes wrote:

    If the Gotrocks have no financial nous they are better off if they utilise the skills of others If, and it is a big if, the others are more skilled.

    In Australia Choice consumer group secret shopped financial advisors acting as a naive investor and found only 3 percent of financial advisors produced a plan that was adequate or better for their needs.

  • Report this Comment On March 10, 2012, at 6:54 PM, Smillerg wrote:

    As a financial advisor myself, I will most certainly agree that there are many investment professionals in the market who provide an added value below that of the fee they charge. As in any profession, however, there will be some who are better than others at the job they do. In theory, the poorly performing advisors will eventually be crowded out of the market.

    More importantly, of any published statistic that compares the portfolios of investors who use advisors (or more accurately, a sample thereof) vs the (sample) portfolio returns of investors who do not, entirely neglects the opportunity cost of time spent on investment research. And as Adam Smith has taught us long ago in Wealth of Nations, it is always more efficient for us to focus on our specialty and outsource any other work so that we can ultimately reach a higher level of long-run consumption.

    So while an attorney, for example, spends 15 hours and $100 per month (on research tools) to net himself $900 with his portfolio, he could have outsourced his research to an investment advisor thus netting only $700 per month on his portfolio, but allocating his 15 extra hours toward his practice at which he charges $200/hr ($200X15hrs = $3000). In this completely hypothetical example, the lawyer is trading his valuable time to focus on one activity while he is more efficient at another.

    Finally, I would just like to say that advisors should also be benefiting their clients through means beyond just portfolio returns.

    And for any advisors who are aware of their inefficiencies and who are unable to earn an alpha beyond the fees you charge, please please please find another career!

  • Report this Comment On March 11, 2012, at 10:14 AM, robertm348 wrote:

    Short of calling them blood-sucking leeches, they may perform a valuable service for people that have no time or interest in the drudgery of investing.

  • Report this Comment On March 11, 2012, at 1:32 PM, snickerdoodle9 wrote:

    As a self directed investor I did a direct 401k rollover last year to my IRA at a discount brokerage firm . As opposed to leaving my money in a 401k ( paying hidden fees and poor fund selections ) I have the luxury of choosing how I want my money invested . Most of all , the transition gave me a better insight and understanding of financial advisors and myself . Many investors who use financial advisors have no clue about how their money is being invested or whether those investments are working for or against them . If you are going to use a financial advisor , become educated , selective , and involved about how and where your money is being invested . Work with your financial advisor as a team . The more that they see how much you know about your investments , the less likely that you will be disappointed as an investor. You can go to the FINRA web sight to find out whether your broker is listed and reputable .

  • Report this Comment On March 11, 2012, at 5:25 PM, bossman5000 wrote:

    Lots of people don't or will never understand technical investing language. That is the segment of the population that investors are targeting. If you're a wise Fool, I think you're doing yourself a disservice paying someone else to manage your financial future.

  • Report this Comment On March 11, 2012, at 9:45 PM, tweenthelines wrote:

    If you trade, you're toast. Stay in control, a good broker will listen, as well you should listen AND filter. Do limit orders on ALL transactions. I spend an inordinate amount of time on research before I jump, and above all I do not listen to anyone on CNBC.

  • Report this Comment On March 12, 2012, at 8:43 AM, mikecart1 wrote:

    Financial Advisors = Fitness Trainers. Neither should be qualified to give the advice they give for the prices they charge. Neither cares more about you than you ever will. Both take a lot more money than they give out as a product. Financial Advisors slowly tank your net wealth at the expense of your time and money for their gain in commissions. Fitness trainers slowly waste your time and put your body in a state of rebounding that will take months or even years to get back to any plan or body you want to achieve.

    Bottom line, stay away from financial advisors and so-called fitness trainers that look like contestants for a Pillsbury Doughboy challenge, and stick with CRammmmmmmmerrrr!!!! .... or at least yourself.

  • Report this Comment On March 12, 2012, at 12:52 PM, hbofbyu wrote:

    Cramer? Please. Any idiot looks good from 2009 to now. For picking stocks I'll stay with my monkey throwing darts.

  • Report this Comment On March 12, 2012, at 3:21 PM, Merton123 wrote:

    I believe Warren Buffet was arguing that passive indexing investment strategy will beat the majority of the active investors through his story. However we do need all of these brokers to encourage people to invest their money into the stock market. So while passive indexing outperforms the majority of the active stock pickers - the brokers are the ones who sell the stock market to people who otherwise wouldn't be investing their hard earned cash in my opinion.

  • Report this Comment On March 12, 2012, at 4:44 PM, devoish wrote:

    Bloomberg TV had an opinion.

    http://www.youtube.com/watch?v=08UPQ3JaRek

    Best wishes,

    Steven

  • Report this Comment On March 12, 2012, at 5:28 PM, wolfmansbrother wrote:

    The fact is the overwhelming majority of money managers under-perform the S&P.

    If you are paying management fees to an adviser or as part of an actively-managed mutual fund and you are not beating the market, then yes, you are being ripped off. Anyone can at least earn the market avg. (minus minimal fees) by investing in an S&P index fund.

  • Report this Comment On March 12, 2012, at 5:37 PM, seattle1115 wrote:

    We can argue about whether the Helpers are adding value (which, it should be recalled, essentially means creating wealth). What is beyond argument, though, is that in this hypothetical the Gotrocks themselves are creating no wealth. Their investments (i.e., all the corporate equity in the economy) may be creating wealth, but not thanks to any active involvement on the part of the Gotrocks. In fact, on the facts presented, the only thing the Gotrocks have done which presents even the possibility of creating new wealth is to hire the Helpers! Otherwise, they're basically dead weight.

    Conclude from that whatever you will.

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